Managing acquisitions to change and survive

It has become conventional wisdom that acquirers suffer by over-paying for targets and then suffering post-acquisition chaos. Indeed, there is almost a cottage industry among analysts in decrying acquisition problems, pointing to the "winner's curse" in which the high bidder over-pays and then fails to gain predicted synergies. At the same time, newspapers and magazines daily highlight failed acquisitions. If we based our assessments of acquisitions only on what we read in the academic and business press, it would be easy to conclude that acquisitions must be about to disappear from business strategy as managers balk at the risks.

Rather than declining, of course, acquisition usage has grown rapidly during the past decade. Global completed mergers and acquisitions value reached $2.2 trillion in 2001 as a result of more than 21,000 deals, according to Thomson Financial. More than 9,000 deals occurred in Europe, 6,000 deals in the US, 2,500 in Asia, plus many more in Australia, Latin America and Canada.

Acquisitions are ubiquitous in all developed economies. Although the $2.2 trillion of global acquisitions activity in 2001 was only 60% of 2000's record high, the number of deals in 2001 reached 86% of the 2000 total. Thus, the apparent decline is primarily a reduction in the magnitude of acquisitions, accompanied by a much smaller reduction in their frequency. Even when considering the value of acquisitions, global activity in 2001 exceeded historic levels for all but the most recent years.

Acquisition activity will remain common even during the current economic slowdown. For strong firms, such as Nokia and General Electric, struggling firms represent opportunities to grow product lines and extend operations. For other companies, such as the Archipelago and Redibook electronic networks, mergers provide an opportunity to change the terms of competition in their industry while competitors such as Nasdaq focus on traditional operations. The core point is that acquisitions are a strategic tool in all economic conditions.

Why, if acquisitions are so problematic, do managers increasingly use acquisitions as an important part of their strategy? Is the US simply levelling the global competitive playing field by exporting a bad managerial practice throughout the world? Should we expect a decline in Asian electronics industries, for instance, because European and American firms are buying companies in Singapore? We do not believe so.

Acquisitions: success or failure and little in-between

Recent acquisitions are occurring for financial and strategic reasons. In part, they reflect the greater availability of capital to finance deals, whether to consolidate declining industries, gain scale economies in stable industries, or change businesses in dynamic industries. As well as financial market growth, though, the strategic power of acquisitions is at least as great a driver of the increased use. Acquisitions have been central to firms such as Siemens, ABB, General Electric, DuPont, Nokia, Nestlé, Singapore Telecom and many others for more than a century to gain new capabilities and explore new opportunities that they could not otherwise create.

Several of our recent studies speak directly to the role of acquisitions in renewing the firm's capabilities and businesses. A study by Laurence Capron (1999) that looked at 250 European and US acquisitions showed that firms that use acquisitions to reshape their technical and commercial capabilities often gain advantages. Karim and Mitchell's (2000) study of several hundred acquisitions in the US medical sector between 1975 and 1995 shows that the acquisitions helped firms gain incremental product advances and substantial changes in product mix. Their 2001 study of medical sector business evolution shows that acquisitions and subsequent business unit reconfiguration underlay more than 65% of the medical products that Johnson & Johnson introduced from the mid-1970s through the mid-1990s. A study of US nursing homes during the 1990s, moreover, demonstrates that nursing home chains changed the operating practices of several thousand facilities that they purchased during the period (Mitchell, et al, 2001). The core conclusion from these studies is that acquisitions help businesses change what they do.

Firms that learn how to use acquisitions to facilitate business change often flourish. General Electric has used hundreds of acquisitions during the past two decades, at times averaging more than an acquisition a week, to change goods, services, and business processes. Similarly, Nokia used acquisitions as a primary driver in its transformation from a Finnish resource firm to the international leader in wireless telecommunications. These firms would not have become world leaders without their acquisition strategies.

At the same time, acquisitions are undoubtedly risky. Failed purchases are common and sometimes lead to corporate failure. Integration problems that arose during Warnaco's series of late 1990s acquisitions, for instance, contributed to the company's 2001 bankruptcy. Compaq's difficulties in integrating Digital Equipment Corporation, which it acquired in 1998, has led to Hewlett-Packard's controversial plan to merge with Compaq. Thus, conventional wisdom is partly wise – acquisitions can cause major problems.

The unconventional truth, though, is that acquisitions are one of the most powerful tools in a manager's toolbox, with the potential to transform a company if the firm uses acquisitions well or to kill the company if the firm uses acquisitions badly. Thus, like any powerful tool, people must learn to use acquisitions effectively or risk damaging their work and careers.

Acquisition strategy

The remainder of this article outlines elements of successful acquisitions strategy. We focus on two stages: assessing opportunities and integrating targets.

Pre-acquisition strategy: There are five elements of pre-acquisition strategy.

1. Identify responsibility for acquisition strategy
   Do you have people who live and breathe for total acquisition success?

   Assign responsibility for guiding acquisition strategy. Clearly, acquisitions strategy must involve senior managers who will determine major objectives and targets. In addition, a corporate development group needs to co-ordinate pre-acquisition assessment and post-acquisition integration. The development group needs to facilitate individual acquisitions and create a coherent overall strategy.

   Of course, most large firms have created corporate development groups. Unfortunately, though, many such groups treat acquisition management as a fragmented series of unrelated decisions, creating conflicts and confusion. A major industrial products firm, for instance, undertook a series of acquisitions over a period of a decade, primarily based on unco-ordinated directions from its senior management. The latter wanted to pursue aggressive growth, but the consequence was a company consisting of many units that shared little common logic and duplicated many activities. Corporate coherence only developed later when the company assigned responsibility for rationalising its acquisition strategy.

2. Develop an acquisition vision
   Do you know what acquisitions will contribute to what you want to achieve as a company?

   Develop an over-arching vision for your acquisition strategy. This means that you have thought through what you want to achieve via acquisitions and have created criteria for selecting targets. For instance, in the early 1990s, Tyco set out on an acquisitions-driven growth strategy within four business segments: electronics, healthcare, security and flow control. The company set four acquisition criteria: a target must be in one of the segments; must expand product lines or improve distribution; must offer excellent growth prospects; and must use familiar technology. The key point is to know what you want to accomplish with an acquisitions strategy and what target characteristics will allow you to do so.

   Part of an acquisitions strategy lies in determining how aggressive to be. Aggressiveness will depend on how much financing is available, how much time is available for integration, and how well developed your integration skill is. Most firms need to digest purchases before undertaking extensive new acquisitions.

   Bank One, for instance, used acquisitions as the primary driver of its growth strategy. It undertook a sequence of acquisitions from the 1970s to the early 1990s in which the company would make extensive acquisitions in one year, followed by a period of low-acquisition digestion. Such sequences allow time to integrate needed parts and divest unneeded portions of targets and existing businesses, before undertaking additional expansion.

   Firms that lack time for digestion risk corporate bloat. Cooper Labs, for instance, grew rapidly in the medical sector via a series of acquisitions during the early 1980s. The expansion succeeded as long as Cooper was able to integrate its growing set of business activities. Continuing with an unchecked pace of acquisitions, however, the company surpassed its integration limits and foundered. In other examples, Lockheed Martin and Raytheon have both struggled to integrate several closely sequenced major acquisitions in the past few years. Tyco's recent plan to split into several independent companies, even though the corporation reported record profitability in 2000 and 2001, is a signal that it has reached the limits of its integration skills and hopes to avoid corporate chaos by spinning off the segments.

3. Identify potential targets and price ranges
   Can you run faster than the market?

   Identify potential targets that fit your acquisitions criteria. High-priority targets offer you the greatest change potential, either to improve the target or to use the target's skills. Simply paying for cash flow from a business that you will continue to operate unchanged is rarely profitable.

   Evaluate the price range that you will be willing to pay for a high-priority target and draft a financing proposal. Begin by looking for comparable recent transactions. Then assess the value of the "fit" between your existing business and the target. The fit will arise through your opportunities to reduce costs, create new goods and services, enter unserved markets, provide superior management, and change business processes. To assess the "fit value", generate scenarios of revenues and costs based on possible combinations of your business and the target business. Make sure that there are enough cost savings and revenue generators to justify the premium so that the target's shareholders don't receive all the value.

   Cost savings and revenue generator synergies must be improvements beyond changes the market anticipates each company would make if the acquisition didn't occur. The market may also add a premium to reflect the likelihood that the company will be acquired, so that the target's market value already reflects some future acquisition synergies.

   The question then becomes: can you run faster than the market? Compared with other bidders, do you have distinct skills to create value with the target? Capron and Pistre (2002) found that mergers created value to acquirers when competitors could not duplicate the synergy and its resulting cash flows, which inhibits competitive bidding. Thus, for acquirers to earn abnormal returns, the difference between the first and second most capable acquirers matters more than absolute value creation. As bidders' capabilities become similar, target shareholders capture most of the value.

4. External contacts, due diligence and offer terms
   Are you willing to commit resources to learn what your target really is worth to you?

   Contact the potential target. This commonly takes the form of a letter of intent expressing interest, followed by a meeting with the target's management. If the deal appears feasible, pre-arrange financing options such as cash, stock, stock swap, debt, subordinated debt, mezzanine financing and seller's notes. The options typically lead to revisions in the letter of intent.

   Carry out a deep investigation of the target and its fit with your existing businesses. Due diligence commonly involves both corporate development staff and outside help from CPAs, law firms, investment bankers, brokers and consultants. If this is a friendly acquisition, then due diligence will usually involve personnel from the target. If the target management resists the offer, of course, they are unlikely to assist. Although unfriendly takeovers are more difficult to price and integrate, they often offer opportunities for valuable changes.

   We stress that simply relying on external help for due diligence causes major problems, because external parties emphasise a target's value in its existing state. For change-oriented acquisitions, the real value of the target depends on how you will use its capabilities to improve your existing capabilities or how you will use your capabilities to change the target. Assessing the change-value requires knowledge of your existing capabilities and innovative assessment of change potential, which requires deep involvement by your corporate development and operating staff.

   Following due diligence, identify an offer price and develop a detailed financial structure. Prices may differ strikingly from the range you identified earlier if due diligence reveals extensive information.

5. Walk away when necessary
   Do you have the discipline to stick to your top terms?

   If a deal goes sour, leave it. Deals sour for many reasons: there is insufficient fit between your needs and a target's capabilities; target management holds out for an unrealistic price; competitors inflate the price; or competitive conditions change. If you treat any one acquisition as part of your acquisitions strategy, then you can avoid over-committing to a deal. Pre-acquisition activities are the easiest part of acquisition strategy but raise critical issues. Many firms fare reasonably well at this stage, especially with the more mechanical steps such as basic due diligence concerning targets' past activities. None the less, firms frequently struggle with qualitative aspects of pre-acquisition strategy, especially in setting a vision to guide their activities and in assessing the costs and benefits of changing capabilities at targets and existing businesses.

   We now move to post-acquisition strategy, where the most difficult problems arise. Although some acquisitions fail simply because they were poor deals – either the wrong target or the wrong price – many failures occur because of post-acquisition mismanagement.

Post-acquisition strategy: We stress six elements of post-acquisition strategy.

1. Create integration teams with people from the target and acquirer companies
   Can you afford time and resources for the nitty-gritty acquisition details?

   Create two types of integration teams, a "guidance team" and as many "operating teams" as necessary. The guidance team sets the direction for acquisition integration, identifying initial goals and evaluating goal changes as integration proceeds. Managers from the acquirer typically need to lead the guidance team, in order to co-ordinate integration with corporate goals. At the same time, a guidance team benefits from support by the target's senior leadership, in assessing the target's capabilities and identifying how people from the target will fit, or not fit, within the combined company. Because senior management of a target often do not remain long within the combined firm, it is important to draw on their knowledge quickly.

   Operating teams carry through detailed integration of target and acquirer capabilities, following trajectories that the guidance team sets. They can also help the guidance team re-evaluate and update the strategic direction of the integration as opportunities that lie beyond the initial objectives emerge in practice. As operating team members, pick the people with the best knowledge, whether they come from the target or the acquirer. Indeed, active participation in an operating team offers a fast track for career development by target personnel.

   Corporate development staff members play critical roles for creating guidance and operating teams. Firms that carry out acquisitions as regular parts of successful change strategies, such as General Electric, Bank One, and ABB, develop consistent systems that they apply to their typical acquisitions. The ability to bring standard systems into play quickly contributes to their long-term success.

   At the same time, corporate development staff must ensure that people do not follow routine systems blindly. "Routinisation" creates major problems when firms unthinkingly use standard approaches to integrate non-standard targets. Many of General Electric's problems following the 1986 Kidder Peabody acquisition, and Bank One's problems with the 1997 First USA acquisition, stemmed from failing to adapt their acquisition integration systems in the face of unusual needs.

2. Achieve quick wins
   Can you fight to avoid post-acquisition lethargy?

   Long-term acquisition success stems from quick wins. Finding the low-hanging fruit of cost savings, process improvements and market entries feeds confidence and creates resources for additional integration. The key point is to identify a big opportunity and achieve it, then move on to the next opportunity. Firms that assess all possible integration options before undertaking any integration find that the opportunities vanish before the integration begins.

   Many opportunities for selective integration arise for quick-acting guidance and operating teams. Combine related products within existing sales forces. Sell unneeded facilities. Adjust prices. Rationalise sourcing choices. Renegotiate supplier and financial terms. Combine administrative services. Eliminate duplicate operations. Increase run lengths. Extend product ranges. Reinforce brands. Reduce discretionary costs... Again, we stress that integration gains can arise without a complete initial over-haul of a target or acquirer.

   Clearly, of course, integration speed depends on how well the acquirer understands the new business context. A distinction arises at this point concerning the relative difficulty of integrating exploitative and exploratory acquisitions. Exploitative acquisitions are acquisitions in which a firm reinforces its existing product lines, production systems and other capabilities. General Electric's recent bid to acquire Honeywell, for instance, was largely an exploitative acquisition, offering opportunities to refine GE's existing instrumentation and electronics capabilities. Similarly, Hewlett-Packard's attempt to purchase Compaq is largely an exploitative acquisition, seeking to reinforce skills in existing computing businesses. By contrast, exploratory acquisitions enter new areas of business activity, technology or geographic markets. Nokia's purchase of a computing business from Ericsson during the late 1980s was an exploratory acquisition, which later contributed to Nokia's mobile telephone business.

   It might, initially, appear more difficult to integrate exploratory acquisitions than exploitative acquisitions. Indeed, this would be true if integration of exploratory and exploitative acquisitions occurred at the same pace. However, exploratory acquisitions tend to benefit from highly selective tapered integration in which the acquirer only gradually combines the new and existing business. Thus, the risks of such exploratory acquisitions arise more from longer-term corporate fragmentation than from lack of immediate integration.

   By contrast, exploitative acquisitions usually require rapid integration in order to generate the cost-savings and revenue growth that arise from the complements among the businesses. Integration costs and difficulties are often high when you add operations to a current product line or expand an operation. For instance, BorgWarner bought Kuhlman Corporation in 1999. Adding Kuhlman's Turbocharger line to BorgWarner's Turbo division required more effort than creating a new Cooling division as an exploratory venture. As a result, firms initially often struggle more with major exploitative acquisitions than with exploratory acquisitions and, in turn, require greater immediate integration skill to manage the latter. One of the reasons for the negative market reaction to the HPCompaq deal, for instance, arises from concerns that the firms lack the acquisition skills needed to carry through the deep integration that the deal will require. By contrast, the market reacted positively to the GE-Honeywell announcement because of GE's successful track record in acquisition integration. A recent study of the US medical sector shows that firms with greater integration capabilities are more likely to undertake exploitative acquisitions than firms with lesser integration capabilities (Mitchell and Shaver, 2001).

   The quick wins of selective integration offer a sequential process toward full integration. Moreover, exploitative acquisitions will require particularly rapid sequential integration. Thus, acquirers need to assess their integration skills credibly when considering a major exploitative acquisition.

   We stress this point owing to the tendency to view related acquisitions as good and unrelated acquisitions as problematic. While we agree that unrelated acquisitions can create long-term problems if firms do not co-ordinate exploratory activities, we believe that seemingly related exploitive acquisitions create the greatest immediate pressures.

3. Reconfigure both the target and the acquirer
   Will you challenge your own business?

   Too often acquirers emphasise the making of changes at the targets, while ignoring opportunities to change their existing businesses. In a study of 250 acquisitions, Laurence Capron (1999) found that the target's assets were three to five times more likely to be divested than the acquirer's assets. By contrast, the greatest advances at firms that develop effective acquisition strategies arise from changing both the target and existing business. Cooper Industries, for instance, used bilateral reconfiguration of its targets and existing businesses to undertake major transformations of its overall industrial products corporation from the 1960s to the 1980s. Our study of acquisitions in Europe and North America during the 1990s found that the greatest benefits for capability improvement arose when firms carried out extensive bilateral reconfiguration, rather than focusing on unilateral resource redeployment to or from targets (Capron and Mitchell, 1998). Operating teams need to identify best practices, whether at the target or acquirer, find opportunities to transfer those practices to relevant locations, and then create new capabilities by combining those practices with existing skills.

4. Divest obsolete capabilities
   Do you have divestiture discipline?

   Firms that carry out active post-acquisition reconfiguration are left with unneeded capabilities as remnants of the target or acquirers' original businesses. Divesting such unneeded resources allows you to focus on high-value opportunities rather than divert attention to peripheral activities.

   Unfortunately, firms sometimes avoid post-acquisition divestitures because they fear that sell-off will signal acquisition failure. We disagree with this view. Instead, divestiture following reconfiguration of targets and existing businesses is part of acquisition success. Firms that have particularly successful acquisition strategies are almost as active in divestiture as in acquisition. General Electric, for instance, acquired more than 300 businesses between 1981 and 1987, while carrying out more than 200 divestitures following extensive changes to the targets. Indeed, a recent study found that divestitures are most common following substantial reconfiguration (Capron, et al, 2001), rather than being sell-offs of unfortunate acquisitions.

5. Integrate people and align incentives
   Are you willing to share your privileges?

   Targets need to become part of the acquirer as quickly as possible. In part, this means aligning incentives of all members of the corporation, whether they have just joined or have spent their entire careers there. Acquisitions threaten careers of managers in both the target and acquirer. Clearly, managers will not carry out acquisition integration that does not match their incentives. You will need to adapt performance measurements and rewards, while defining transitional objectives and longer-term goals.

   In addition, acquirers need to create a language in which people view the target as an integral part of the combined business. In a simple sense, this means renaming the businesses as quickly as possible. In a more subtle sense, you need to develop communication flows that include new and existing personnel. Cases in which people from a target business continue to refer to themselves in terms of their original business fall far below their integration potential.

6. Assess regularly
   Are you willing to challenge the raison d'être of your acquisitions?

   Finally, we stress that it is necessary to review the success and failures of individual acquisitions, as well as the logic of your acquisition strategy. At least once a year, firms need to assess the progress and outcome of each recent acquisition. In addition, you need to regularly review the vision for your acquisition strategy and the responsibilities for managing the strategy.

Conclusion

Acquisitions are among the most powerful tools for business change. Done well, acquisitions can drive fundamental change to how your business operates and provide a basis for growth and survival. Done badly, acquisitions lead to quick decline and failure. We urge each manager to assess his/her firm's acquisition strategy carefully and to help improve it where needed.

Will Mitchell is the J Rex Fuqua International Management Professor at Duke University's Fuqua School of Business. Laurence Capron is Associate Professor of Strategy and Management, INSEAD, France.

This article was first published in European Business Forum, Issue 9, spring 2002.